Principle of Lower of Cost and Market Price

While adopting any of the six methods [(a) to (f)] described under Section , two aspects must be highlighted for the information of those responsible for inventory valuation. Firstly, a method once chosen should be consistently followed. Secondly, the basic convention of "conservatism" and "prudence"  must also be observed and practiced. This convention enjoins that anticipated losses should be included when determining the profit or loss of a period though such losses have not actually been suffered. For this reason, inventories may (have to) be valued at market prices (how they can be sold out) if these prices are lower than cost prices (as recorded in the books). Then, by implication in the balancing relationship discussed in Section , with the cost of inventory being less than their cost price, the figure of the cost of goods sold is automatically inflated by the implied loss in the inventory value due to adopting the (lower) market price. To overcome the several difficulties arising from this conceptually inflated sales (revenue) figure (by balancing the equation), this inflated figure of cost of goods sold should have to be given under its two obvious components, viz. 

(a)  the actual cost of the items sold; and 

(b)  the part arising from balancing the loss due to undervaluation of the inventory at market value instead of at cost. But in periods when the market value (equal\ or) is higher than cost, the inventory would be valued only at cost; and the second component referred to above will not exist. Hence, if "lower of cost or market price" principle is adopted for inventory valuation, and if the market prices fluctuate above and below the cost price, the cost of goods sold will not be uniform over the different periods. This will make any comparison of working results (of the business through several periods) meaningless. To make them comparable, the loss if any due to undervaluation of inventory will have to be adjusted separately.